I have successfully avoided reading anything about this Volcker Rule for around three years. Why are you harshing my mellow?

Let’s strike a deal: you can resume ignoring the Volcker Rule shortly but pay attention just today, because it’s a really important day in the history of US financial regulation, and it could change the way the entire financial system works. So just take a few minutes and then go back to ignoring it.

That’s a compelling offer. I can’t wait to start ignoring this tomorrow. Okay, so talk me through this. Start at the top. Paul Volcker – why do we care what he thinks about the financial system? I mean, everyone’s a critic, right?

Paul Volcker is not just a critic. He’s the 86-year-old former chairman of the Federal Reserve and all-around wise man in finance who believes the financial system is not working the way it should be.

Three years ago, when Congress was talking about Dodd-Frank financial reform, he started worrying about something: banks were taking big risks by investing their money in stocks, bonds, commodities and other risky assets. That was called proprietary trading, and it was kept hidden from the public.

Volcker envisioned a day when a bank would make a big, secret stupid bet with its own money, and then it would lose so much money that it would hurt the rest of us: either the bank would be in so much trouble that our deposits would be at risk, or the bank would require a bailout, or both. Volcker wanted to find a way to prevent that. So he (and hundreds of other people) started writing the Volcker Rule.

It’s worse than that, actually. Volcker first started talking about the rule in 2009, so it’s really more like four years. And the rules don’t really go into effect until July 21, 2015 for banks overseen by the Federal Reserve. Midsize banks, with less than $50bn in assets, have until 2016. Small banks – the ones with less than $10bn in assets – don’t have to start fully cooperating until 2017. So we’re talking about an eight-year gestation period in some cases.

Okay, but wait. You said that Volcker was worried about banks making stupid investments. What’s wrong with banks investing in things? If I had money, I’d be investing in all sorts of things.

Theoretically, nothing’s wrong with investing, except that banks are bad at it and, as we saw in 2008, when they make bad decisions we have to bail them out. Banks lose absurd amounts of money on proprietary bets all the time; $1bn isn’t unusual, and some, like the London Whale trade, lose $6bn.

Losing more money than you make. Hmmm. That sounds like … not a smart business model.

Yeah, but there’s a reason banks stay in that business. When they hit the jackpot they really hit it. Like a gambler, that chance of a win keeps them in the game, even if it’s only a temporary profit. And anyway, when banks lose money, their executives don’t lose their personal fortunes for the most part. So there’s really no incentive for those executives to stop allowing stupid trading decisions.

I see where that could get thorny. But has that actually happened? Has any bank lost money for its shareholders by using deposits to make bad bets?

I’m so glad you asked. Do you remember the London Whale scandal? It’s all explained here, if you want to revisit it. The bank had a $350bn “chief investment office” that was fueled purely by “excess customer deposits.” That bet went bad and JP Morgan lost $6 billion. The bank is so profitable that it could absorb the loss – that time. That kind of thing would be a violation of the Volcker Rule now.

I’m not sure I really understand proprietary trading and why it’s a problem. Can we go over that again?

Sure. Think about it this way: for years, banks were middlemen, buying and selling things for other people. They’d find a good price, and then broker a deal. They were in the moving business, shuffling securities like stocks, bonds, commodities and derivatives out the door as fast as they came in, from this guy to that guy. That is called “market making”.

Sometimes their customers would want to take big risks, say, that General Motors stock would go down. But any bet can go wrong. So the banks would find a way to help the companies hedge their bets: if they bet that one stock or bond would go up, the bank would help them find another one that would go down. That way, the company wouldn’t lose all its money on a single bet. That’s called “hedging”.

Here’s the twist: in both market-making and hedging, banks hold on to the stocks or bonds or derivatives temporarily until they find a buyer on the other side.

But you can’t see that temporary money in your account, watching all that money passing by you, walking through the building, and not want a cut, right? So more and more banks have been stepping into the center of trades, looking at what customers are doing and then taking a chunk of those deals for themselves to make a profit on the side.

I think I’m getting closer to getting it. Is there a more tangible way to see it?

“It might be easier if you think of stocks and bonds like rugs, and think of the banks like rug merchants. So what is the job of a rug merchant? He buys rugs from the makers, and sells them to other people. But he also keeps some of the inventory for himself – the rugs that he thinks will be valuable one day.

Banks are exactly like that. They buy and sell stocks for their clients, and then there's some stuff off to the side that they are holding onto – that they think is the really good stuff. The Volcker Rule wants the banks to stop hoarding rugs, because sometimes, those rugs don't turn out to be really valuable. They turn out to be junk. And then, when the rug merchant – or the bank – has too many worthless rugs, the government tends to come in and as we know, bail them out.”

Buying and selling those rugs on the side is how banks do proprietary trading. Investment banks like to make investments with “their own money” in things like stocks, bonds, real estate, and commodities.

Wait. Why did you put “their own money” in scare quotes? Isn’t it their money?

Well, banks don’t really have their “own money” any more. A long time ago, investment banks used to be partnerships owned by small families or groups of rich men, all Rothschilds and Lazards and such, and they actually did put their own money, from their own bank accounts, into things like oil wells in Nigeria and Russia. They still made stupid bets often, but they lost only their own money if they did.

And now?

Since 2000, though, banks don’t have their “own money” in that way. Banks now almost purely consist of other people’s money. Almost all the big banks are public companies, listed on major stock exchanges. JP Morgan, Citigroup, Goldman Sachs, Morgan Stanley – all public companies, just like Apple or GM. Their owners are not rich bankers; their owners are anyone who buys their stock. The benefit of being public is that banks have a lot more money to play with – all those delicious billions from shareholders! It’s a nice little cushion for stupid bets.

Plus, all the big banks get the privilege of borrowing money really cheaply from the Federal Reserve. So that’s already a subsidy for them to help them make profits. The idea that banks have their “own money” is a convenient illusion. If JP Morgan CEO Jamie Dimon or Goldman Sachs CEO Lloyd Blankfein or Citigroup CEO Michael Corbat allow bad trades, they don’t lose any of their personal fortunes.

But isn’t that what banks do? They take our deposits and take risks with them. They take those stupid risks to make more profits, probably. And when banks are profitable, isn’t that better for everyone? It’s better than bailing them out all the time.

That’s right about taking risks with deposits. But it’s not just making a profit that counts – it’s how they make a profit. In the words of the great Lebowski, “this isn’t ‘Nam. There are rules.” It’s about taking manageable risks. Usually, things like loans are manageable risks; the math on them isn’t too hard, and you can generally predict the losses. Things like complex mortgage securities are not, because almost no one is smart enough to know what they’re worth. When banks take risks and make money, it’s great. When they lose money, taxpayers have to step in to bail them out.

The Volcker Rule is, for some, a way to bring back some order in the markets, a kind of nostalgia for a simpler time.

I think I read about this! The Glass-Steagall Act, right? That was a big deal for Occupy Wall Street.

Exactly. Investment banks and commercial banks were kept separated between the 1930s and 2000 by a law called Glass-Steagall. The purpose of Glass-Steagall was to prevent banks from taking stupid bets with customer money.

What was the difference between investment banks and commercial banks?

It’s easy. Think of investment banks as the adrenaline-driven businesses. Investment banks mostly existed to handle the markets – stocks, bonds, commodities, derivatives, advising companies on mergers or bankruptcies. They were risky, so they weren’t allowed to get bailouts or special lending rates from the government.

Now all the big investment banks are gone. Bear Stearns and Lehman collapsed, and Morgan Stanley and Goldman Sachs were forced to become commercial banks in 2008 during the financial crisis so the government could bail them out.

And commercial banks?

Then we had banks that existed to take care of our deposits, and they weren’t making bets on the markets; they were called commercial banks. Those banks took our deposits and made loans to people and companies. That kept money moving through the country and the financial system. You’re part of it. Whenever you put your paycheck in your savings account, you get an interest rate, right? That interest rate is actually a rental payment from the bank to keep your money with them. In turn, by depositing the money, you’re giving the bank permission to take the money in your savings account and rent it out to other people in the form of loans and mortgages.

The banks make their profits by taking the difference between the low interest rate they pay you on savings, and the slightly higher interest rate they charge other people to borrow money.

Okay. I think I get it. All our banks are now commercial banks that hold our deposits and Paul Volcker doesn’t want them to do stupid gambling things with our money.